JOBS Act: A potential boon for entrepreneurs or a bust for investors?

ByOlga Khazan

March 22, 2012

Many entrepreneurs are cheering for the swift passage of the JOBS Act, the package of six bills that aims to ease small business’s access to capital markets. The Senate on Thursday passed the Jumpstart Our Business Startups Act (JOBS Act) by 73 to 26 two weeks after the House approved it, sending the Senate version to the House for reconciliation.

The JOBS Act addresses many of the problems that investors and start-ups alike have for years said plague the venture market — namely, that small companies lack the ability to raise money from hundreds of small equity investors and that their ability to “go public” is hindered by what they feel are overly cumbersome financial disclosure requirements.

However, some analysts say that certain provisions of the bill threaten to open the floodgates for the defrauding of investors and should be pulled from the final version of the bill.

Two big problems

The bill aims to address the fact that the early-stage venture market is tight and geographically exclusive by making it easier for start-ups to raise money from multitude investors. According to a January study conducted by Pepperdine University in Malibu, Calif., and by small-business credit rating company Dun and Bradstreet Credibility Corp., “increased access to capital” was cited by the most small and medium-sized business owners (30 percent) as the best way to “help spur U.S. job creation in 2012 versus 2011.” That was followed closely by “regulatory reform,” with 28 percent of the votes.

The JOBS Act addresses those two issues, mirroring elements from President Obama’s Startup Agenda, a series of reforms the president proposed in January. One is the introduction of crowdfunding, which some say would open up fledgling businesses to money from myriad small-dollar equity investors. Under current laws, companies cannot solicit capital in exchange for equity from hundreds of un-accredited investors.

In January, University of Pennsylvania Wharton School of Business professor Patrick FitzGerald explained why that might be advantageous for start-ups:

“If you can only pitch to angels and VCs, your investment world is much smaller than if you could pitch the idea to lots of people who have $1,000 each, for example,” he said. “If crowdfunding passes, that should radically change the game in terms of how fast companies can grow.”

Under the JOBS bill, companies seeking crowdfunding investment would still file with the Securities and Exchange Commission. The Senate’s Merkley-Bennet-Brown amendment aims to protect investors by limiting individuals with an annual income or net worth of less than $100,000 to investing 5 percent of their income in crowdfunding.

The measure would also loosen regulatory requirements for smaller companies seeking to go public, creating a new classification called “emerging growth companies.” For companies with less than $1 billion in revenue, the number of audited financial statements required for an IPO would be reduced and those companies would be exempted from having to hire an external auditor. Furthermore, it provides for “mini” public offerings, under which companies raising $50 million or less to avoid some of the financial disclosure requirements that most publicly held companies fall under.

Cheers and questions

Many in the start-up community have rallied around the act as a way to boost the growth of businesses and allow more of them to go public. Startup America chair and former AOL chief Steve Case has been Tweeting for its passage from the outset, and more than 5,000 entrepreneurs and investors have signed a letter to Senate leaders in support of the bill, arguing it “cut[s] the red tape that prevents many rapidly growing startup companies from raising needed capital.”

Some founders are overjoyed at the thought of the freer movement of money through crowd-funding.

“I’ve been following the crowdfunding piece, and I think it rocks,” said Dan Berger, the founder of SocialTables in Washington. “Investing in start-ups has been relegated to the wealthy for the longest time, but with crowdfunding the process will give more entrepreneurs access to capital and more citizens the opportunity to strike gold.”

Writing at Xconomy, Harvard Business School professor Bill Sahlman argued that the bill would allow more companies to go public, a major growth point in the life of a business:

“When you lower the cost of doing something, more of it gets done. That’s simple economics, and that’s the thrust of the JOBS Act,” he writes.

But Jeffrey Stibel, CEO of Dun and Bradstreet Credibility Corp, which worked on the Pepperdine study, said there are pitfalls to having more investors participating in the financing of small companies. He supports the bill but believes many of the relaxations in regulatory structures pave the way for shady bankers to swindle unwitting investors.

“Under this bill, you can now go to my grandmother and say, ‘I want you to invest in a company,’ but the whole thing can be effectively a scam and you’ve just created the air of legitimacy to skirt the law,” he said. “Previously, you had to go to a qualified investor, who has enough sophistication to sniff out fraud.”

Stibel said that a potentially damaging provision is one that allows securities analysts covering these new “emerging-growth,” or small, companies to collude with the banking arms of investment companies on stock research, thereby potentially opening the door for analysts to become mouthpieces for certain stocks rather than impartial observers.

Many investors have argued that type of relationship between analysts and banks is necessary because research analysts wouldn’t otherwise be able to cover small companies at all.

“The trading volume for small companies isn’t big enough to support a research analyst, so they can’t go public because there’s no one telling their story,” said Paul Maeder, an investor with Highland Capital Partners in Cambridge, Mass.

But Stibel said he believes it’s a bridge too far:

“That entire provision around marketing and promoting should be removed,” he said. “Focus on crowdsourcing, freeing up regulations around raising money and I think you will have done the small business and entrepreneurial environment a huge service.”

Correction: This article has been updated to include Sen. Michael Bennet, who also worked on the Senate’s amendment.